Assets

1./ If you have an asset – in the example I use a house – worth $200,000 and your loan on the house is $150,000 (liability), then you have $50,000 left in equity.

Imagine that a company buys trucks for its operations, buying other businesses, real estate or even inventory: Those are all assets.

What this means is that if you have a good new idea you can either pay for it yourself, you can borrow the money or use some combination of the two.

2./ The idea behind buying an asset is that you will make money in the end.

If for instance we use the example of a company buying delivery trucks – then the company needs to pay for it in order to get cash back in return.

The GAP definition of an asset is that it will provide a probable future economic benefit to the owner.

Liabilities

A liability is a promise to pay back the loan plus interest on that loan.

If the Company defaults on its loan, the house will go to the bank. That is a contractual obligation.

If you default on the loan, the bank gets paid first. That is also true in business. The person or the entity that has loaned the money gets paid first.

Equity

In the example above, there is $50,000 in equity.

If the bank is only able to get $100,000 for the house – that doesn’t cover the debt, but it’s all they get – you will get nothing.

If anything is left over, you will get it.

The way to think about it is whatever is left over after you pay all the Bankers.

Finance

The definition of finance is as follows:

What this means is:

What should we invest in?

Should we use cash (equity) or should we incur debt?

The future is unknown which makes finance difficult.

The third point comes from the fact that finance is all about the future and since the future is unknown finance is difficult.

What we do in finance is that we are looking into the future and doing lots of estimates to decide what to do.

Goal of Corporate Financial Manager

The goal of financial management is to maximize the current value per share of existing stock (market value of equity).

Theoretically this is a good goal because the owners own the company and the financial manager works for the owners.

However, there are a few problems and let’s look at a few of them:

1./ The Agency Problem with Corporations

This is what the Agency Problem means:

The shareholders own the company and are what is called “principal”.

The managers run the business and are what is called “agents”.

According to the definition an “agent” is working for somebody and in this case for the shareholders or the “principal”.

The agent is supposed to act in the best interest of the principal.

But because the agent is inside the company the agent has custody of the assets.

Managers do not always act ethically or legally.

Question: If the principal is not watching the agent 100% of the time how can the principal make sure that the agent is always acting in their best interest?

Answer:

Pay managers based on stock value of the company.

External auditors of the financial situation of the company to the Board of Directors. The role of the auditors is to control the financial information of the company so that it comes out to its owners, regulators and potential investors. If the auditors have no direct interest in the company, it makes the situation slightly better.

Control over assets and accounting. This means that before the management even gets hold of any books they are supposed to be managed properly by somebody associated with principal.

Make management personally responsible for the financial statements.

Regulation as for an insurance. If you come in a buy a car insurance, the insurance is obliged by law to hold money aside if there’s an accident.

There are many examples in financial history of companies having gone out and borrowed money in the market.

This money has then been accounted for as debt on the balance sheet just as it should be (a liability).

But then they bought the debt back and recorded the debt as an asset on the balance sheet instead.

This is fraud and illegal.

Another example is insurance companies that invented policies that circumvented the regulations and the law.

This was also illegal.

3./ Financial markets are efficient.

The definition of finance depends on financial markets being efficient.

What that means is that the assets are accurately priced in the market.

Obviously, we all know that this is not always true, but as a general rule it should hold.

However, there have been two major bubbles over the past 20 years:

The dot com-bubble of the late nineties.

The housing bubble between 2003 and 2007.

When you have a bubble, the market is telling you that the companies, or more broadly, the assets involved are worth a lot of money, but they are not.

What can happen then is that the bubble pops and loses all its inflated value at once.

This way a lot of people can lose a lot of money quickly.

If there is a manager inside a company and he/she is trying to maximize the value of the company, but the market value is not fair, the goal itself cannot be achieved.

That means that everyone is left guessing what the market value of the company is.

Here’s an example of a house in 2003 to 2007:

Figure 5. The housing bubble of the 2000’s explained with ever increasing house values.

The market was telling the participants that houses worth more and more during the bubble years, but they were not as we could see when the bubble popped in 2007.

The process can be summarized like so:

The markets said that house prices were worth a lot. This was a price signal to buy houses as an investment.

The banks, who make loans for a living, the individual, who buy houses, and the contractor, who build the houses, all reacted to that price signal.

Market was incorrectly giving people the signal to buy.

Why should we study finance?

There are of course several reasons why you would want to study finance.

First of all we have the Personal side:

Student loans

Credit cards

Investments

Retirement savings

Banking

What are the careers that you can have in finance?

Marketing (budgets, analyze market plan)

Accounting and finance (have a lot in common)

Management (investing, what projects are best given current circumstances, job performance)

Personal finance

Other areas of finance

In this class we are going to study corporate finance, but there are other areas of finance as well:

a. Investing

Stockbroker (where you buy and sell stock for customers)

Portfolio manager (where you buy and sell stock for a mutual or index fund)

Security analyst (where you do all the research and pick the individual stocks)

Bond trader (where you buy and sell bonds for customers)

b. Financial institutions

Banks

Insurance

c. International finance

What questions to ask?

Capital budgeting: What long-term investments or assets do we buy? This includes equipment, buildings and investments.

Capital structure: Are you going finance your investments with debt, equity or profits? What mixture of those are you going to use?

Working capital: This is the nuts and bolts of running the company. The Working capital is defined as Current assets – Current liabilities and by definition this is short-term. How do we collect money from our customers to pay our bills? Concerned with short-term assets and liabilities.

Cash flow

In finance cash flow is everything.

This is an example of how cash can flow through a corporation:

Figure 6. Chart showing the flow of cash in a corporation.

In the figure it says A. The Firm issues securities. That can be the company having an initial public offering or an IPO.

Then people in financial markets decide to buy some stock so the cash goes from right to left and into the business.

Then we have B. Firm invest in assets which can be that the company buys for example machines or buildings.

Why is the company buying the assets? They of course do it to get a return on their investment.

Then we have C. Cash flow from Firm’s assets. This means that the company has earned a return on its investments and now the cash is flowing in three different directions:

Back to the financial markets

D. It can go to the government or other stakeholders in the form of taxes.

E. The cash can be reinvested in the company.

The take home message here is that in finance what matters is Cash flow and not accounting numbers.

The first part in using Microsoft Excel as a finance tool can be found here and part 3 can be found here.